Friday, October 7, 2016

Discussion Post - When Genius Failed (Chapter 7)

In 1998, Long Term began to short equity volatility. This
idea, referred to as “equity vol”, comes from the Black-Scholes model. This
model and the theory behind it assumes the volatility of stocks is consistent
over time. This economic model along with many others told firms equity vol was
being mispriced, and the firms began to bet against it.

An equity vol isn’t an explicit stock or security, but there
is an indirect way to bet on it. Lowenstein describes betting on the volatility
of the market as an analogy of betting on the weather in Florida. The price of
orange juice fluctuates according to the odds of a frost occurring, so one can
infer high orange juice prices may represent the market is expecting a frost
and a shortage of oranges. Similarly, Long Term deduced the stock market was
expecting volatility at 20% when it was really closer to 15%. Assuming option
prices would sooner or later fall, Long Term then began to short options on the
S&P 500 index, calling it “selling volatility”. This was considered to be
very risky, as volatility is not easily predictable, fluctuates on a daily
basis, there is a small market for selling volatility, and international
markets too play a role in volatility.

1998 started off well, Long Term’s leverage was up, and even
though the partners took out huge personal loans, their exposure seemed to be
appropriate. Partners at Long Term weren’t anxious of losing, they were anxious
about finding enough investments to win. Long Term began to make more
directional bets instead of their landmark hedging strategy. However, partners
at Long Term began to lose patience in researching and analyzing trades and
there began internal conflict within the partnership; tensions which Wall
Street knew nothing about. Banks and other firms soon began to cut back on less
liquid bonds, which were the kind of bonds Long Term’s portfolio consisted of.
A Salomon trader in London noted that “as people liquidated, volatility moved
up. That forced more people to liquidate.”

Soon the US economy as a whole began to slow. Yields on Treasuries
fell to 6.7%. Russia’s financial system was on the verge of collapse. The IMF
bailout in Indonesia also ran into some difficulties. The Swiss bank was also completely
exposed as it was Long Term’s largest investor.

Things continued to look down, as Long Term began losing
money in every market it was a part of. The stock market was suddenly very
volatile, and option prices jumped. Implied volatility rose to 27%, creating a
substantial loss for Long Term as it had shorted equity vol at far lower
levels. In June, Long Term experienced its worst month ever, losing 10%.

In April of 1998, the swap spread in the US was 48 basis
points. This is the difference between the LIBOR and the Treasury yield. Long
Term however, had bet this spread would narrow as Long Term saw no recession on
the horizon.

In July, Salomon announced its exit from US arbitrage,
declaring “Opportunity for arbitrage profits has lessened over time while the
risks and volatility have grown.” Long Term partners underestimated the
seriousness of the net largest player in their business quitting.

In August, The US was affected by the crisis in Russia even
after its IMF bailout, weakness in Asia, Iraq’s refusal to permit weapon
inspections, the possibility of China’s currency devaluing, and presidential tumult.
Thirty-year bond yields hit another all-time low, reaching 5.56%, and credit
spreads kept widening. Long Term was losing money in August, for the third
month of four. Long Term partners were optimistic, thinking the spread would
have to eventually narrow. Long Term decided to jump more into Russia, where it
already owned both hedged and unhedged bonds. Even though it was against Long
Term’s way, it went long into Russia, which was now the spectacle of the entire
world.

Questions

-What is the relationship noted about liquidation
and volatility?

-What did it mean to bet on volatility?

-What was the risk associated with arbitrage?

-How did the strategy and mind set of Long Term
change throughout the chapter?